Some Valuable Remarks About Oil and Speculation

Last night I participated in a debate (arranged by Russia Today TV - 24-7 - CrossTalk, and transmitted internationally in English) in which I pointed out - on several occasions - that the aggregate (though unweighted) Brent-WTI (West Texas Intermediate) price of oil was about 112 dollars a barrel (= $112/b), and I claimed that if this price reaches $130, we could be facing a clear and impending economic danger.

Early this morning, when I checked this aggregate price on the important sites OilPrice.Com and 321 Energy, it was almost $115/b. I therefore decided to inform my friends and neighbours that an increase of the nature is the worst possible news at the present time, because the global macroeconomy is definitely not in the best condition. I can also note that while that debate was stimulating, in addition it confirmed two things that many colleagues seem to have overlooked.

First, over the last year or two, the most important components of the oil scene are at last on the fringe of being completely understood by many persons only moderately interested in that topic, by which I mean that oil is physically and not just geopolitically scarce, and its price has a considerable macroeconomic influence. Moreover, the new North American oil promise - e.g. oil sands in Canada and Bakken oil in the U.S. - may turn out to be a false dawn, at least in terms of the dawn that we need, and perhaps absolutely must have.

I also attempted to inform the other participants in the debate, and the audience, that the full story dealing with the availability of physical oil and its relation to the macroeconomy can best be obtained from the work of Professor James Hamilton of the University of California, San Diego, whose most recent contributions can be found on OilPrice.Com. Hamilton may be the best student in the world of the oil price and its macroeconomic effects, and he has something to say on this topic that should not be ignored.

All of this is on the positive side of the debate. On the negative side it was clear that the role of speculation is still not adequately understood. There is unfortunately still an unfounded belief somewhere - perhaps everywhere - that the world would be a better place if financial institutions - voluntarily or otherwise - stayed away from paper assets having to do with physical oil.

My view of this is quite simple, and I am glad to report that almost all of my students at the Asian Institute of Technology (Bangkok) and Uppsala University understood its basic elements perfectly, even if many outside my classrooms adamantly refuse to do so. As an example, in 2008, when the price of oil was going into orbit, and threatened to ruin the global economy, President George W. Bush did not take a helicopter or bus to New York and Wall Street, and lecture the young 'masters of the universe' (as they are sometimes called) on their irresponsibility or incompetence.

Instead he took Air Force 1 to Saudi Arabia, where his visit probably ended with the famous Turkish adieu, 'smiling may you go, and smiling may you come again', even if with all this smiling little or nothing was said or done about increasing the flow of oil. Of course, more than thirty years ago the then king of Saudi Arabia said that his country would never provide a sustainable output of more than ten million barrels a day (= 10mb/d), and if domestic consumption is considered, it means that at the present time Saudi exports are slowly declining.

Let me make a prediction. Those exports are declining and they will continue to do so, although if the oil price duplicated its escalation of 2008, an attempt would probably be made to provide more oil for the export market. The question is how much could be made available in the short or medium run, if the talk about making oil available was more than fantasy or empty promises. I tell my students and anybody else with an interest in the topic that the correct answer is very little, and the main issue is not willingness but ability. In addition to sustainable capacity (of about 10 mb/d) it is possible to refer to a Saudi surge capacity (of an extra 1.5-2 mb/d), but surge capacity means exactly that. It cannot be maintained indefinitely, and some insiders have started to claim that an output of 10 mb/d can only be perpetuated with difficulty.

Now for the bottom line in my argument. Speculators react to changes or possible changes in the oil price due to what is taking place on the supply-demand front, or what they perceive is taking place or could take place in the light of present market dynamics! They don't - and for the most part can't - initiate these changes, although there is no point in denying that occasionally conditions prevail in which speculators have a marginal influence. Yes, I know of cases in which speculators apparently were able to initiate a price spike of one sort or another in which somebody might make a lot of money, and maybe there were some negative macroeconomic overtones, but spikes do not count in the present oil market setting. The spectacular oil price rise of 2008 (which actually began several years earlier "when it was brilliantly referred to by Daniel Yergin as a "slow motion oil price escalation") was a disaster because of its impact on the global economy. In a sense it too may have begun as a spike, but a spike that got out of control. The fundamental mechanics consisted of demand outrunning supply.

Moreover, there is something else that I like to stress that everyone should make an effort to understand and appreciate. What happened after the oil price topped out (at $147/b), and rapidly declined to $32/b, gave OPEC an opportunity to show its power. They had another of those famous meetings in marvellous Vienna or somewhere, and the next thing we knew the price had unexpectedly recovered to more than $70/b. That recovery had nothing to do with speculators. It was caused by OPEC reducing the quantity of the oil it supplied to the market.

All of this is expanded on in detail in Chapter 3 of my new energy economics textbook , but although my future students will be expected to understand it perfectly if they prefer a passing to a failing grade, everybody else need only understand that the dramatic talk about oil and speculation that is resonating through the blogosphere and on the op-ed pages of many newspapers should be taken with a grain of salt. More optimistically, if you get over with this fixation on speculation, you can easily and with authority and style discuss the global or a regional oil market in any gathering anywhere in the world.